Wall Street Prep: Interpreting Non-GAAP Reports

Foreword

I was a newbie to finance when I took this course, so this is a high-level take from me trying to understand the industry for the first-time and just “speak the language”.

Notes

1. Introduction to Non-GAAP Reports: Non-GAAP reports refer to financial statements that deviate from the standard, generally accepted accounting principles (GAAP). Companies often use them to provide a clearer picture of their financial health, excluding extraordinary items.
2. Why Non-GAAP?: While GAAP provides a standard and consistent approach, it might not always reflect the operational reality of a business. Non-GAAP metrics can help bridge this gap.
3. Common Non-GAAP Adjustments:
• Stock-based compensation: Companies might exclude this because it doesn't represent cash outflow.
• Amortization of acquired intangible assets: This could be seen as not directly related to core business operations.
• Restructuring charges: Non-recurring charges that can distort the understanding of ongoing operations.
4. Critics of Non-GAAP Reporting: Critics argue that these reports can be misleading. For instance, by excluding certain costs, a company might appear more profitable than it is in reality.
5. Importance of SEC Guidelines: The U.S. Securities and Exchange Commission (SEC) has issued guidelines on non-GAAP financial measures to prevent misleading presentations.
6. Reconciliation is Crucial: Anytime a company presents non-GAAP measures, they must reconcile them with the most directly comparable GAAP measures. This helps investors see the differences clearly.
7. Focus on EBITDA: EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It's a popular non-GAAP metric, providing insight into a company's operational profitability.
8. Example of EBITDA Calculation:

EBITDA=Net Income+Interest+Taxes+Depreciation+Amortization

(this is going backwards)

9. Adjusted EBITDA: Some companies further adjust EBITDA by excluding items like stock-based compensation or one-time charges.
10. Free Cash Flow (FCF): Another popular non-GAAP metric, it represents the cash a company generates after accounting for cash outflows. It gives a clear picture of how much cash is available for shareholders.
11. FCF Calculation:

FCF=Operating Cash Flow−Capital Expenditures

12. Non-GAAP Revenue Adjustments: Sometimes, companies adjust revenues for items like foreign exchange impacts or acquisitions.
13. Non-GAAP Expense Adjustments: Companies might exclude certain expenses, like litigation costs, to show operational efficiency.
14. Potential for Manipulation: Non-GAAP measures can be manipulated to present a rosier picture. It's essential to analyze the reasons behind adjustments.
15. Case Study on EBITDA Manipulation: A company increased its EBITDA by capitalizing expenses that should have been treated as operational costs, thereby inflating profits.
16. Importance of Auditor's Role: Auditors must ensure that non-GAAP disclosures don't mislead investors and are consistent year-over-year.
17. SEC's Emphasis on Transparency: The SEC insists that non-GAAP measures shouldn't be given more prominence than GAAP measures in reports.
18. Exclusion of Non-recurring Items: Non-GAAP often excludes non-recurring items. However, if a company continually excludes the same "non-recurring" item year-after-year, it's a red flag.
19. Usefulness in M&A: In mergers and acquisitions, non-GAAP metrics can provide a clearer picture of a target company's value by excluding one-time integration costs.
20. Comparability Challenge: Different companies might have different non-GAAP adjustments, making it hard to compare them side-by-side.
21. Non-GAAP in Earnings Calls: CEOs and CFOs often refer to non-GAAP metrics in earnings calls to highlight operational strengths. However, always look for reconciliation with GAAP measures.
22. Adjusted EPS (Earnings Per Share): Another common non-GAAP metric. Companies might adjust EPS for items like restructuring costs to provide a clearer earnings picture.
23. The Rise of Non-GAAP: Over the years, there's been an increasing trend of companies reporting non-GAAP metrics, emphasizing their importance in modern financial analysis.
24. Beware of "Creative" Metrics: Some companies introduce unique non-GAAP metrics. Always understand the rationale behind such measures.
25. Case Study on Misleading Non-GAAP: A tech company excluded stock-based compensation from its non-GAAP measures, painting a deceptive profitability picture.
26. Non-GAAP in Different Industries: Different sectors have specific non-GAAP measures. For instance, SaaS companies might focus on metrics like Monthly Recurring Revenue (MRR).
27. Tax Effects and Non-GAAP: Companies often adjust for tax effects when presenting non-GAAP earnings to provide clarity.
28. SEC Scrutiny and Non-GAAP: The SEC periodically reviews companies' use of non-GAAP metrics to ensure compliance with guidelines.
29. Non-GAAP Outside the U.S.: Non-GAAP reporting isn't unique to the U.S. Other countries have similar practices but might have different names, like "Alternative Performance Measures" in Europe.
30. Non-GAAP in Forecasts: Companies might provide forecasts using non-GAAP measures. Ensure these forecasts also have GAAP equivalents.
31. The Role of Analysts: Financial analysts often use non-GAAP measures in their models. They must ensure they understand the adjustments made.
32. Analyzing Non-GAAP Trends: If a company's GAAP and non-GAAP earnings trends diverge significantly over time, it's essential to understand why.
33. Debate on Stock-based Compensation: While many companies exclude stock-based compensation in non-GAAP, critics argue that since it's a real cost, it shouldn't be excluded.
34. Influence of Activist Investors: Some activist investors prefer non-GAAP metrics, believing they provide a clearer picture of a company's health.
35. Liquidity Measures vs. Performance Measures: The SEC categorizes non-GAAP measures into these two. For example, EBITDA is a performance measure, while FCF is a liquidity measure.
36. Presentation of Non-GAAP: Companies can't present non-GAAP measures in a way that's misleading or hides poor performance.
37. Adjusted Gross Margin: Some companies adjust gross margins for items like inventory write-downs to provide a clearer operational picture.
38. Use in Debt Covenants: Some debt agreements might have covenants based on non-GAAP metrics. This underscores their importance in finance.
39. Role of Media: The media often quotes non-GAAP figures in headlines. Investors must delve deeper and not take these figures at face value.
40. Per-share Non-GAAP Measures: If presenting non-GAAP measures on a per-share basis, companies must ensure they're not misleading.
41. Industry-specific Non-GAAP: For example, real estate companies might use Funds from Operations (FFO) as a non-GAAP measure.
42. Non-GAAP and Compensation: Some companies tie executive compensation to non-GAAP metrics. Analyze if this could incentivize the wrong behavior.
43. Growth vs. Profitability Debate: While GAAP might focus on profitability, non-GAAP can sometimes emphasize growth metrics more, especially in industries like tech.
44. Understanding Context: Always interpret non-GAAP metrics in the context of a company's industry, business model, and specific challenges.
45. Non-GAAP in IPOs: Companies going public might use non-GAAP metrics in their prospectus. Potential investors should ensure they understand these metrics and their implications.
46. The Role of Non-GAAP in Valuations: Valuation experts often use non-GAAP measures to derive a company's intrinsic value, especially if they believe these metrics provide a clearer picture of future cash flows.
47. Regulatory Changes and Impacts: Regulatory changes can sometimes affect both GAAP and non-GAAP figures. For instance, a change in tax law might lead to adjustments in both types of metrics.
48. Depreciation, Depletion, and Amortization: These are standard add-backs in EBITDA but understand the rationale behind them. For instance, in capital-intensive industries, depreciation can be a significant expense.
49. Consistency in Non-GAAP Reporting: Companies should be consistent in their non-GAAP adjustments year-over-year. Changing the adjustments frequently can be a red flag.
50. Communicating Non-GAAP Metrics: Companies should clearly communicate the reasons behind using specific non-GAAP metrics and how they provide a clearer financial picture.
51. Impairment Charges and Non-GAAP: Companies might exclude impairment charges in non-GAAP metrics, arguing they're non-recurring. However, frequent impairment charges might indicate deeper operational issues.
52. Peer Comparison Using Non-GAAP: When comparing peers, ensure they use similar non-GAAP adjustments. Otherwise, the comparison might be skewed.
53. Non-GAAP in Credit Ratings: Credit rating agencies might use non-GAAP metrics to gauge a company's ability to service its debt.
54. Evolution of Non-GAAP Metrics: As business models evolve, especially with the rise of digital economies, non-GAAP metrics might evolve too. For instance, user growth might be a key metric for a social media company.
55. Challenges in Global Companies: For global companies, currency fluctuations can have a significant impact. Some companies use non-GAAP metrics to present figures on a constant currency basis.
56. Acquisition-related Costs: These are often excluded in non-GAAP measures, but if a company is frequently acquiring others, it's worth questioning if these costs are genuinely non-recurring.
57. The Future of Non-GAAP: With increasing scrutiny from regulators and investors, non-GAAP metrics might become more standardized in the future.
58. Risk of Over-reliance: While non-GAAP can provide valuable insights, over-relying on them at the expense of GAAP metrics can be risky.
59. The Debate on Normalized Earnings: Some argue that non-GAAP metrics provide "normalized" earnings, which show a company's earning power without one-time disruptions.
60. Role of Academic Research: Several academic studies have explored the validity and usefulness of non-GAAP metrics, with mixed findings.
61. Limitations of EBITDA: While EBITDA can be useful, it doesn't account for changes in working capital or capital expenditures, which are crucial for understanding cash flows.
62. Non-GAAP in Bankruptcy Analysis: When analyzing distressed companies, non-GAAP metrics can sometimes provide insights into a company's core earning power, excluding restructuring costs.
63. Sector-specific Challenges: In sectors like biotech, where R&D costs are significant, the debate around capitalizing vs. expensing these costs can lead to non-GAAP adjustments.
64. Role of Investor Relations: The investor relations team plays a crucial role in communicating the rationale behind non-GAAP metrics to the investor community.
65. Non-GAAP in Equity Research: Equity research reports often contain both GAAP and non-GAAP estimates, reflecting the importance of both in stock valuation.
66. The Controversy Around Adjusted Revenues: While adjusting earnings is more common, some companies also adjust revenues. This can be more controversial and requires careful scrutiny.
67. Tax Rate Adjustments: Some companies present non-GAAP earnings using a normalized tax rate, arguing it provides a clearer earnings picture.
68. The "Why" Behind Non-GAAP: Always ask why a company is using a particular non-GAAP metric. The answer can provide insights into its operations and challenges
69. Importance of Footnotes: Often, the details of non-GAAP adjustments are buried in footnotes. Always read them.
70. Non-GAAP and Share Buybacks: Companies might use non-GAAP earnings to justify share buyback programs, arguing they reflect true earning power
71. Use of Non-GAAP in Bond Offerings: Similar to equity offerings, bond prospectuses might also contain non-GAAP metrics to highlight a company's ability to service debt.
72. Non-GAAP and Stakeholder Communication: Companies should communicate non-GAAP metrics to all stakeholders, including employees, to ensure everyone is on the same page
73. Non-GAAP in Budgeting and Forecasting: Internally, companies might use non-GAAP metrics for budgeting, reflecting their importance in strategic planning